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Thursday, September 30, 2010

TARP was an essential piece of a necessary evil – that is, it saved the American financial system from collapse, but it was put in place in a way that was excessively favorable to the very bankers who had presided over the collapse. And this sets up exactly the wrong incentives as we head into the next credit cycle.

[G]overnment interventions, of which the TARP was a key part, prevented what leaders in the early 1930s did not—a cascade of wealth-destroying, money-supply shrinking bank failures. And because the interventions successfully halted the cycle of fear in financial markets, the programme ended up costing practically nothing... The truth is that the TARP, despite the profit, has come with significant negative costs. It has preserved the structure of the banking system in its current, over-concentrated, too-big-to-fail form. And it has created an absolutely massive moral hazard problem. And so in a way, we're all still paying the cost of TARP, because the legacy of that intervention continues act as a de facto subsidy to size and risk. And one day that bill may come due, in the form of another costly crisis.

There areotherobservers, on the other hand, who sing nothing but praise for TARP. If it were possible, it would be useful to look at the difference between (1) the net present value of future costs created by TARP and (2) the costs that would have been incurred in 2008 and 2009 had there been no TARP. Of course, such a calculation is not possible because (1) requires knowledge of the future and (2) requires knowledge of a counterfactual. One thing, though, does seems sure to me: the moral hazard problem is now bigger than ever.

I like to point out that in June of 2008 the Federal Reserve forecast real GDP growth in 2009 of 2.0% to 2.8%, when in fact the economy shrank in 2009 by over 2%. Of course, this doesn't mean that central banks have no basis on which to make policy. All they need do is look at the evidence in front of them... In late 2008, the Fed might have taken comfort from its forecasts. Had it been looking at market signals—falling equity and commodity prices, a rising dollar, and movements in bond yields—the need for aggressive monetary easing would have seemed clear.

In other words, beginning around mid-2008 the Fed passively allowed market conditions to deteriorate and did so all the way up to the financial blow-up in September. The Fed's actions during this time were not enough to stem the growing demand for liquidity. The Fed, therefore, was effectively tightening monetary policy by failing to accommodate this growth in money demand. This passive tightening by the Fed prior to the crisis can be seen below: (Click on figure to enlarge.)

This figure shows the spread between the nominal and real yield on 5-year treasuries. It fell about 170 basis points during the period leading up to the collapse of Lehman in September. Normally, this spread is interpreted as the expected inflation rate. In this case, it shows a decline in inflation expectations that in turn suggests a deterioration in expected aggregate spending (assuming no big increases in expected productivity). It is likely that this spread was also reflecting a heightened liquidity premium during this time. Here, the implication is the same. A heightened liquidity premium indicates increased demand for highly liquid assets like treasuries and money that, in turn, also imply less aggregate spending. Both interpretations point to the Fed allowing monetary policy to passively tighten during this time. This passive tightening was unfortunate and most likely contributed to the severity of the financial crisis. That being said, it pales in comparison to the passive tightening of monetary policy that occurred after the Lehman collapse. Thus, I have classified the July-September period in the figure as the passive mild tightening of monetary policy and the September-December period as the passive sharp tightening of monetary policy.

Wednesday, September 29, 2010

Martin Wolf reminds us why good macroeconomic analysis is not always intuitive:

Analysis of the economy is not the same thing as analysing a single household. What is true of the latter is not true of the former. The unwillingness to recognise this truth will lead to serious policy mistakes.

The policy mistake to which Martin Wolf is referencing is the call for more economic austerity. He notes that though increased austerity may be a good idea for a given household it is not necessarily true for the entire economy. He is alluding here to the Paradox of Thrift, the idea that if everyone tries to save--which makes sense individually--during a recession, then aggregate spending will fall. In turn, this will lower both aggregate income and total saving (i.e. there would be less income from which to save). As a result, the economy will tank even more making it harder to service the existing debt. Thus, Martin Wolf concludes more borrowing may be just what the economy currently needs.

While provocative, the paradox of thrift idea is really nothing more than another way of saying there is a monetary disequilibrium created by an excess demand for money. And, of course, an excess demand for money is best solved by increasing the quantity of money. The painful alternative is to let the excess money demand lead to a decline in total current dollar spending and deflation until money demand equals money supply. Another way of saying this, is that the paradox of thrift requires the Fed to be asleep on the job.

Let me explain why the Paradox of Thrift is really just an excess demand for money problem. First, individual households can save three ways: (1) by cutting back on consumer spending and hoarding money, (2) by spending income on stocks, bonds, or real estate and (3) by paying down debt. In the first case, all households attempt to increase their holdings of money by cutting back on expenditures. However, if there is a fixed amount of money this will create an excess demand for it and a painful adjustment process will occur. If , on the other hand, the Fed adjusts the money supply to match the increased money demand then the painful adjustment is avoided and monetary equilibrium is maintained. In the latter two cases where assets are bought and debt is paid down the money is passed on to the seller of the assets or to the creditor. Here, the only way to generate the painful adjustment is for the seller or creditor--or any other party down the money exchange line--to hoard the money. If the creditor or seller does not hoard the money then it continues to support spending and price stability. All is well. Increased austerity, then, only becomes an economy-wide problem when it leads to an excess demand for money. Bill Woolsey sums it up best:

[S]aving can only generate the sort of cumulative rot that would create a paradox of thrift if it either directly or indirectly creates an excess demand for money. There is nothing to the paradox of thrift other than a distorted version of the fundamental proposition of monetary theory.

The fundamental proposition of monetary theory is that an individual household can adjust its money stock to the amount demanded, but the economy as a whole cannot. The economy must adjust its money demand to the given stock of money and this can be very painful. The question then is how best to maintain monetary equilibrium. My answer is to have the Fed stabilize aggregate spending.

Update I: Nick Rowe responds in the comment section. Along with Bill Woolsey, he is one of the resident experts in blogosphere on the importance of money as a medium of exchange and its implications for monetary disequilibrium. For example, see this post and this one on his blog.

Update II: If you hang around long in the economic blogosphere you likely to get the famed Brad DeLong smackdown applied to you. I got my own today and it actually was quite pleasant. Here is Brad:

The hole in David's argument is, I think, where he says "the Fed adjusts the money supply" without saying how... So, yes, Beckworth is right in saying that there is an excess demand for money. But he is wrong in saying that the Federal Reserve can resolve it easily by merely "adjust[ing] the money supply. The problem is that--when the underlying problem is that the full-employment planned demand for safe assets is greater than the supply--each increase in the money supply created by open-market operations is offset by an equal increase in money demand as people who used to hold government bonds as their safe assets find that they have been taken away and increase their demand for liquid cash money to hold as a safe asset instead.

Increasing the money supply can help--but only if the Federal Reserve does it without its policies keeping the supply of safe assets constant. Print up some extra cash and have the government spend it. Drop extra cash from helicopters. Have the government spend and by borrowing to finance it, create additional safe assets in the form of additional government debt. Guarantee private bonds and make them safe. Conduct open market operations not in short-term safe Treasuries but in other, risky assets and so have your open market operations not hold the economy's stock of safe assets constant but increase it instead.

I agree with Brad's concern that something more than normal monetary policy is needed here to accommodate the excess money demand. I have discussed some of theseideas before on this blog. Interestingly, Brad's discussion takes us full circle back to Martin Wolf's solution of more government borrowing. All I would add is that fundamentally this is still an excess money demand problem.

Monday, September 27, 2010

Scott Sumner has twonew posts up that speaks to something that has been bugging me lately: the increasing popularity of an explicit inflation target for the Fed. Many bloggers, including myself, have been calling for the Fed to create more inflation or at least stabilize inflation expectations. I have been particularly vocal on the latter point. Others have been more forceful in their call for an explicit inflation target as a means to increase the inflation rate. All along, my reason for arguing for the Fed to stabilize inflation expectations is that doing so would indicate the Fed is stabilizing expectations of future aggregate demand (given that productivity does not appear to be contributing to drop in inflation expectations). Such actions, in turn, would also serve to stabilize current aggregate demand as well.

Now, I have never been enthusiastic about stabilizing inflation as an end in itself. The reason being is straightforward: inflation is a symptom, not an underlying cause. More generally, the percentage change in the price level could be the result of shocks to aggregate demand (AD), aggregate supply (AS), or both. Currently, it seems clear that the drop in inflation expectations and the drop in core inflation are reflecting faltering aggregate demand. Thus, it makes sense to talk about the need to arrest these drops. However, it need not always be the case--low inflation could also be the symptom of a positive AS shock (e.g. productivity boom). Imagine, for example, aliens land and give us new technology that makes our computers faster, gives us clean energy, and allows us to travel to distant galaxies. Such an alien encounter would create mother of all productivity booms. Among other things, this productivity boom would imply a higher neutral interest rate, lower inflation rate, and robust AD growth (given the increase in expected future income). In such a case a rigid inflation target of say 4%, as somehave proposed, would not make sense here. Most likely it would be too high an inflation rate to keep AD stable.

Another way of saying all of this is that monetary policy should focus only on that over which it has meaningful control: total current dollar spending or AD. It should ignore AS shocks, both the good and the bad, because all it can do by responding to such shocks is to make matters worse as alluded to above. Focusing too narrowly on an inflation target--which assumes every shock is an AD one--can cause a central bank to make this very mistake. I made this case before in more detail in this post which got some play time in the economics blogosphere (e.g. Mark Thoma reposted it here). My hope was that this post would help folks see that the stabilization of AD rather than inflation targeting should be the key objective of monetary policy.

So what kind of monetary policy would serve to consistently stabilize AD? The answer is one that directly targets a stable growth path for AD. This could be a NGDP target or a final sales of domestic output target or any measure that directly aims to stabilize the growth of total current dollar spending. Scott Sumner outlines its advantages in a recent post, but let me add a few thoughts. First, an AD target is easy to implement. All it requires is a measure of the current dollar value of the economy. It does not require debates over the proper inflation measure, inflation target, output gap measure, and coefficient weights that plagued inflation targeting and the Taylor Rule. Second, it can easily be made into a forward-looking rule by having the Fed targeting the market's forecast of AD. This would require some innovations such as NGDP futures market, but it is within the realm of possibilities as shown by Scott Sumner. Finally, it could be easily communicated to and understood by the public by labeling it along the line of a "total cash spending target."

Update: Karl Smith replies to Scott Sumner and me on this issue. One point Karl brings up is the possibility that a NGDP target could increase macroeconomic instability. Bennett McCallum addressed this issue a while back and showed that this need not be the case if there is forward looking behavior. More recently, Kaushik Mitra showed that even with adaptive expectation-type behavior NGDP targeting can work well.

Thursday, September 23, 2010

Many times I have discussed here how the Eurozone is far from an optimal currency area--its member countries have different business cycles and insufficient economic shock absorbers in place--and the problems that this reality creates for the ECB in conducting monetary policy. One of the key problems is that the ECB is applying a-one-size-fits-all monetary policy to vastly different economies. For example, consider the case of Ireland and Germany. When the Euro was adopted in 1999 Ireland was growing close to 10% while Germany was growing around 3%. Should the ECB be responding to Ireland, Germany, or the average in setting its target interest rates? As the figure below shows, up through the end of the housing boom period Ireland was consistently growing faster than Germany. (Click on figure to enlarge.)

Via Ralph Atkins we learn of Barclays Capital report that looks closely at this issue. Unsurprisingly, it finds the following:

ECB interest rates have generally corresponded more to economic conditions in Germany - the eurozone’s biggest economy - than the eurozone as a whole.

This means ECB monetary policy was well-suited for the low-growth German economy, but way too easy for the hot Irish economy. Easy monetary policy, therefore, must have been an important contributor to the housing boom in Ireland during this time. I think Josh Hendrickson would agree.

There has been an uptick in the discussion of what exactly the Fed should do to stabilize aggregate spending. Folks like Kevin Drum and Matthew Yglesias love it since it gives cover for the Fed to be more aggressive. Well, it seems the folks behind the Wizard of Id comic strip have been reading these blogs because today they came up with their own radical proposal: (Click on figure to enlarge.)

Actually, this proposal is not that new as it was recently promoted by Greg Mankiw and William Buiter. This approach does create some serious problems as noted by Rajiv Shastri, but it would be highly effective in stimulating aggregate spending. My preference is to go with Scott Sumner's proposal.

Tuesday, September 21, 2010

You may have missed it, but this afternoon a slumbering giant with a formidable arsenal of economic weapons began to awake. That giant is the Fed and its formidable arsenal is its ability to further expand its balance sheet and shape nominal expectations. Though the Fed did not fully awake today, it showed signs of awareness that have been absent in the past few months. Specifically, this excerpt from the FOMC press release reveals the Fed is becoming more concerned about the low levels of inflation:

Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.

The Fed is finally getting concerned that inflation--a symptom of aggregate spending--is not where it should be. As Colin Barr notes, this is the Fed's first explicit acknowledgment of this worrying development and it implies the Fed is one step closer to a further loosening of monetary policy. Ryan Avent agrees on this point.

So the slumbering giant is awakening. However, there seems to be quite a bit more awakening to do because the excerpt above claims that "long-term inflation expectations are stable." Take a real close look at my previous post. Using different measures, this post shows that long-term inflation expectations are not stable. This part of the statement leaves me puzzled.

Overall, though, this is an improvement over the outcome from the last FOMC meeting. Maybe Santa Claus Bernanke will grant me my Christmas wish after all.

Update: A number of Wall Street economists also view this statement as a step closer toward further monetary easing. It will be interesting to see if the market via changes in expected inflation, value of the dollar, and other asset prices agrees.

Monday, September 20, 2010

As you prepare for an important FOMC meeting, I would like to direct your attention to several graphs and ask that you consider their implications. First up is a figure of monthly expected inflation across different horizons that comes from the Cleveland Fed. The data is based, in part, on the Treasury market. This figure shows expected inflation in September 2009 and in September 2010. Note that the one-year inflation forecast over the last year went from 2.38% to 0.90% while the ten-year forecast moved from 2.03% to 1.54%. As I have shown before, a dramatic downward trend underlies these differences: (Click on figure to enlarge.)

Second up is a figure showing the 10-year average CPI inflation forecast from the Philadelphia Fed's Survey of Professional Forecasters. This survey is on a quarterly frequency, but tells a similar story to the monthly Cleveland Fed data: there has been a downward trend over the last year or so: (Click on figure to enlarge.)

Third up is the mean quarterly forecast (median is similar) of nominal GDP from this same survey. It too shows a decline in the forecast: (Click on Figure to enlarge.)

In short, whether it is market-driven data (Cleveland Fed) or survey data (Philadelphia Fed), the nominal economic outlook is down. Now the Fed can shape nominal expectations if it really wanted to so, but according to these figures it is not. How do you as a member of the FOMC interpret this passivity? Would it be too much to say that by failing to act the FOMC is effectively tightening monetary policy? This is something I would like you to consider this evening and as you do your final preparations for the big meeting tomorrow.

Oh, one more thing. The figure below shows the historical growth rate of actual aggregate demand (AD), as measured by final sales of domestic output, up through 2010:Q2. Based on one of my more popular blog posts, I have added some labels to this figure which comes from the St. Louis Fed. This figure shows that not only was there a Great AD Crash, but the AD recovery is far from complete. Between the declining forecast above and this incomplete AD recovery does it not seem that monetary policy should be doing more? (Click on Figure to Enlarge)

Thanks for listening and I look forward to your valiant efforts to stabilize aggregate spending.

Sunday, September 19, 2010

Chevelle explains how to do quantitative easing (QE) so that it actually stabilizes aggregate demand. The previous round of QE--called "credit easing" by Bernanke--was not effective in shoring up nominal spending because it was geared towards stabilizing the financial system. I would complement Chevelle's proposal with an explicit nominal target (e.g. NGDP target, price level target, inflation target, etc.). That is, have the Fed announced it will do QE until some nominal target is reached and maintained.

Speaking of nominal targets, Niklas Blanchard calls for an explicit one along the lines of what they have in New Zealand. He says we should abandon the myth of central bank independence and have Congresss enforce a nominal target on the Fed. He would prefer a NGDP target--me too--but could settle for anything at this point.

Tyler Cowen provides further discussion on his New York Times piece on the Fed. Among other things, he (1) reminds conservative inflation hawks that Regan's robust recovery involved inflation above 3%, (2) notes that higher inflation would help the housing market, and (3) says he is open to NGDP targeting.

Scott Sumner says it is time for monetary soul-searching on the left. He notes that the more liberal mainstream media is currently abuzz about the "massively consequential decisions" now facing the Fed and wonders where such questions were back in late 2008 and early 2009. Back then, the mainstream media was focused on fiscal policy and largely ignored the power of monetary policy, the very issue they are now pushing so hard.

Josh Hendrickson looks at the Eurozone during the credit and housing boom and during the subsequent bust. He believes the evidence points to monetary policy being too loose during the boom and too tight during the bust. I think this may have something to do with the Fed's monetary superpower status.

Tyler Cowen made the case today that the Fed has not been expansionary enough:

The economy needs help, but monetary policy, which is the Fed’s responsibility, has not been very expansionary. This is true even though the Fed has increased the monetary base enormously since the onset of the financial crisis. How can this be? Supplying more money did not actually result in enough additional spending. The debilitating financial shock of the last few years convinced many consumers and businesses that they needed to save more. So they are holding on to much of the new money. Given this problem, there is a logical and seemingly simple move available to the Fed: just make people believe that it is seriously committed to increasing the rate of inflation...If the Fed promises to keep increasing the money supply until prices rise by, say, 3 percent a year, people should eventually start spending.... Sadly, although Mr. Bernanke clearly understands the problem, the Fed hasn’t been acting with much conviction.

I'll say, just look at the two figures below which show the expected CPI inflation rates at different forecast horizons. The data comes from the Cleveland Fed and is based on a model that uses information from, among other places, the Treasury market in a manner that controls for the liquidity premium. The first figure below shows the "term structure" of expected inflation in September, 2010 and compares it to September, 2009, a year earlier. The term structure or the plotted curves in the figure show the average expected inflation rate at different yearly horizons. These figures show a striking drop in expected inflation over the past year. The one-year inflation forecast went from 2.38% to 0.90% while the ten-year forecast moved from 2.03% to 1.54% (Click on figure to enlarge).

Lest you think I picked two arbitrary data points for comparison, the figure below shows the values for these horizons over the past year along with a fitted linear trend. Here we see unmistakable downward trends for both series (Click on figure to enlarge).

These figures underscore Tyler Cowen's point that the Fed has not been expansionary enough. They show lower expected inflation across all horizons which implies the the market also expects weaker aggregate spending in the future. Moreover, since the Fed has done nothing meaningful to arrest these downward trends these figures also indicate the Fed is effectively tightening monetary policy! I have made this point many times before using the implied expected inflation rates coming from Treasury Inflation Protected Securities (TIPS). The reason I keep coming back to this issue is because it is mind-boggling that Fed could be so passive at a time like this. There are big-time balance sheets problems in the U.S. economy right now, particularly in the household sector, and the last thing we need are further declines in nominal economic expectations. Yet, the Fed seems intent on letting such expectations steadily fall. I just don't get it. And I bet that Milton Friedman wouldn't get it either if he were alive today. The Fed cannot solve all of our problems, but it can stabilize nominal expectations which would add a lot more certainty to our economic environment. Until it starts doing so all I can wonder is "Dude, where's my central bank?"

Thursday, September 16, 2010

Just when we begin to see some positive economicnews we are reminded by Nouriel Roubini that the Eurozone mess is back. In fact, it never left but was simply ignored over the summer following the trillion dollar palliative in May. Now that summer is over and folks are beginning to realize nothing fundamentally changed over this period sovereign credit spreads are back up to where they were at the height of the crisis. Here is Roubini's conclusion:

So a eurozone that needs fiscal austerity, structural reforms, and appropriate macroeconomic and financial policies is weakened politically at both the EU and national levels. That is why my best-case scenario is that the eurozone somehow muddles through in the next few years; at worst (and with a probability of more than one-third), the eurozone will break up, owing to a combination of sovereign debt restructurings and exits by some weaker economies.

So I guess this means we can once again look forward to a further drop in Treasury yields and lengthy blog discussions on optimal currency areas. I am also guessing this will reinforce the downward march of inflation expectations which left unchecked will mean a further passive tightening of U.S.monetary policy. What a great way to head into the holiday season. At least I know what I want for Christmas.

Update: Here is a picture of the sovereign credit spreads that comes from the Atlanta Fed (click on figure to enlarge):

Are clergy part of the homo economicus clan? Do they respond to resources constraints, incentives, and opportunity costs? A new study sheds some light on this issue by examining whether individuals considering seminary enrollment respond to something more than just a 'higher calling.' Specifically, this study assesses whether prospective seminarians are responsive to wage differentials and swings in the business cycle. Here is the abstract:

Heeding the Call: Seminary Enrollment and the Business Cycle by D.R. Hughes, D.T. Mitchell, and D.P. MolinariWe examine a panel of divinity school enrollments to explore the motivations of prospective clergy considering post-graduate training in preparation for the ministry. Employing the fixed-effects within estimator allows us to see pecuniary motivations while controlling for the differences between types of divinity school and denomination. We find decisions by prospective clergy to enroll in seminary are responsive to changes in the business cycle as well as salaries. Our results reinforce the view that variation in opportunity costs associated with business cycles plays a significant role in the timing of human capital formation even for those with mostly nonmonetary motivations.

So yes, prospective seminarians are responsive on the margin to market signals. They too are part of the homo economicus clan. These findings are consistent with those studies that show there is a countercyclical component to religiosity.

Wednesday, September 15, 2010

Given all the chatter and consternation today about Japan's attempts to keep its currency cheap, it was nice to be reminded by Barry Eichengreen (via Mark Thoma) that we have seen this competitive devaluation story before and it actually turned out okay. Specifically, he points us to the 1930s (my emphasis):

In the 1930s, it is true, with one country after another depreciating its currency, no one ended up gaining competitiveness relative to anyone else. And no country succeeded in exporting its way out of the depression, since there was no one to sell additional exports to. But this was not what mattered. What mattered was that one country after another moved to loosen monetary policy because it no longer had to worry about defending the exchange rate. And this monetary stimulus, felt worldwide, was probably the single most important factor initiating and sustaining economic recovery.

Eichengreen goes on to say that coordinated devaluations would be better since they would minimize volatility in exchange rates and thus in global trade. Whether or not this coordination happens, the key insight here is that some currency devaluation may be exactly what the world economy needs right now. Ryan Avent agrees:

A bit of inflation in Japan wouldn't just be a good thing. It would be a really, really great thing. And if other countries react to Japan's intervention by attempting to print and sell their own currencies in order to toss the deflationary potato to someone else, well then so much the better...Not every country can simultaneously depreciate its currency. But everyone can nonetheless benefit from the attempt, if currency interventions lead to expanded money supplies and rising inflation expectations.

It would be nice to bring some international coordination into play here. Of course, coordinated interventions can have their drawbacks too. Many folks blame Japan's asset bubbles in the mid-to-late 1980s (and by implication its subsequent bust) on the 1987 Louvre Accord. In fact, intervention on this level makes me a little nervous along the lines of Hayek's The Fatal Conceit. Still, if currency devaluation becomes the new game in town it is probably best that it be done thoughtfully and that requires international coordination.

Tuesday, September 14, 2010

Tyler Cowen sends us to an interesting paper by Doug Irwin on the gold standard and the Great Depression. This paper shows via a counterfactual exercise that had the United States and France not sterilized their large gold inflows the price-specie-flow mechanism would have worked its magic and the world would have avoided the destructive deflations of 1929-1933. Others have made this argument before, particularly advocates of the gold standard. They contend that it wasn't the gold standard per se, but the failure of the U.S. and French monetary authorities to play by the "rules of the game" for the international gold standard (i.e. they should not have sterilized their gold inflows). So let's do our own counterfactual: what if the rules of the game had been followed and, as a result, the Great Depression had been avoided across the world in the 1930s. How would the world be different today?

There are probably a thousand different answers one could give--Peter Temin and Barry Eichengreen argue the Nazis would not have risen to power in Germany--but I want to focus on just one possibility: we could still be on the gold standard today. Had this happened what else in monetary history would be different? Would the Great Inflation of the 1970s been avoided? If so, then Paul Volker wouldn't be the legend he is today because there would be no inflation monster for him to slay. Presumably, under such a system the Fed would not have helped fuel a housing boom in the 2000s. With a gold standard, it also seems the Fed would be smaller and the Fed chairman wold be less important--no Greenspan Maestro. Similarly, there would be little-to-no uncertainty over FOMC meetings since their decisions would largely be driven by the gold standard. We wouldn't be worked up over the Senate's delay of the President's Fed appointments since they really wouldn't matter. In many ways it seems that there would be more certainty in this system than what we have under current arrangements. On the other hand, there is no reason to believe in this counterfactual that all nations would continue to play by the rules of the game necessary for an international gold standard to work. And it is not clear that the painful price adjustments required in a gold standard from a money demand shock would be politically feasible forever (of course it such price adjustments were common then maybe prices would be more flexible). In short, one could easily construct a gold standard scenrio where things go terribly wrong again at some later date.

Monday, September 13, 2010

Everyone knows that deflation is a horrible thing: the price level declines, profits fall, employment drops, real debt burdens increase, households in turn spend less, prices fall again, and the cycle repeats. Folks like Paul Krugman, Greg Ip, and Barry Ritholtz have been reminding us of these dangers as there seems to be a greater chance that deflation could reemerge soon. David Leonhardt weighs in on this issue and notes that the sustained lack of inflation in the last two years is unprecedented in the postwar period, except for that "unusual" 1950s period:

Since the Labor Department started keeping records in 1947, there have been only six six-month periods when prices have fallen more than [the past six months]. All of them were in 1950, an unusual time when prices were falling even though the economy was growing.

Gasp. How can it be? Deflation and a growing economy? There must be some mistake because observers like Paul, Greg, and Barry have told us this is impossible. Surely, Leonhardt misread the data. So what the does the data actually show? Let's see, the Fred database shows....gasp. It worse than Leonhardt reports. Looking at the year 1950--the first of these unusual six periods--one finds not only deflation but also solid growth in aggregate demand, corporate profits, employment, and financial intermediation. These developments are not suppose to happen with deflation! Oh my, how can this be? Maybe our high priest of central banking, Ben Bernanke, can shed some light on this mystery. He did, after all, make a famous speech in 2002 that touched on deflation. Now let's see, what did he said in that speech:

The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.(1) Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress.

Thanks Bernanke, but this analysis is not helpful. It is essentially the same thing said by Paul, Greg, and Barry and therefore does not shed any light on the 1950 deflation episode. But wait, Bernanke does have that footnote (1) above. Let's see what it says:

Conceivably, deflation could also be caused by a sudden, large expansion in aggregate supply arising, for example, from rapid gains in productivity and broadly declining costs. I don't know of any unambiguous example of a supply-side deflation, although China in recent years is a possible case. Note that a supply-side deflation would be associated with an economic boom rather than a recession.

Wow, now that is different. And wait, it is consistent with the 1950 deflation experience because there was a productivity boom then. Ok, now that the high priest has said it is possible to have deflation and robust economic growth let's think through the implications of such a productivity-driven deflation. First, laborers should not get shafted even if there are sticky wages. Their real wage should increase through the drop in the price level–workers’ purchasing power will rise. Second, firms' profits should not be harmed either since the productivity gains are lowering their per unit costs of production which offsets the fall in the output price. Third, any unexpected increases in real debt burdens should be matched by unexpected increases in real incomes–no debt deflation problems. Fourth, financial intermediation should not suffer since the productivity boom increases expected future earnings and thus assets prices (i.e. collateral values) go up–no balance sheet problems. Finally, the productivity surge should push up the real interest rate and provide an offset to the deflation drag on the nominal interest rates. Thus, the zero bound is unlikely to be a problem. Aggregate supply (AS)-induced deflation, then, is a lot different than aggregate demand (AD)-induced deflation.

Clearly, the deflationary threat now facing the U.S. economy is of the AD-induced kind. I am concerned about it and have called on the Fed to be more responsive to this potential threat. With that said, this deflation distinction is more than some trivial academic argument. It helps shed light on why the Fed's decision to keep interest rates so low for so long were disastrous in the early-to-mid 2000s. The Fed saw sustained disinflation and and assumed it was the result of faltering AD. The data is now very clear that the deflationary pressures were more the result of the 2002-2004 productivity boom. The productivity boom implied inflation should have been lower, the neutral interest rate higher, and the economic recovery was not in jeopardy. The Fed thought otherwise and, as a result, helped fuel one of the largest credit and housing booms in history. The irony in all of this is that the Fed's fear of deflation in 2002-2004 caused it to act in a manner that help put in a motion a cumulative process that is likely to create the very thing it was trying to avoid in the first place: deflation. Know your deflations!

Update: Some folks have noted that there were several recessions in the 1950s associated with deflation. Great, but that is not what I am getting at here. Most everyone can tell a story about how recessions can create deflationary pressures. Few, however, have an easy time accepting that an economic expansion can also occur with deflation. My focus here was on just the 1950-1951 episode--a clear cut case of the latter. Pointing to the other 1950 episodes is besides the point because they are of the former kind and easy to explain.

Thursday, September 9, 2010

Sigh. The Wall Street Journal had a symposium on monetary policy where it asked six prominent monetary economists what the Fed should do next. Via Mark Thoma we see that five out of six responded with answers that effectively amount to a tightening of monetary policy. Now most of them did not call for an outright tightening of monetary policy, but they did in one form or the other call for passiveness on part of the Fed. Unfortunately, that is not a great idea right now since inflation expectations and aggregate demand forecasts are falling. Doing nothing to arrest these declines amounts to a tightening of monetary policy. Ben Bernanke makes this very point in his recent speech at the Jackson Hole conference. There he argued that by failing to stabilize the Fed's balance sheet the Fed was passively tightening monetary policy. The same goes for failing to stabilize inflation and aggregate demand forecast since these developments affect current spending decisions as well as future ones. Now I respect many of the economists in this symposium so it pains me to say this, but I see no other option. Doing nothing amounts to failure for monetary policy.

Fortunately, one of the participants did make a reasonable suggestion. Here is Vincent Reinhart:

The Fed should promise to purchase government and mortgage-related securities between its regularly scheduled meetings as long as activity is forecast to be subpar and inflation is low or headed down. Purchases of, say, $100 billion every six-to-eight weeks would add up to a number worthy of shock and awe for those with a somber economic outlook.

But those foreseeing a quick return to above-trend growth or expecting a slower trend would similarly be reassured that the Fed would not keep its foot on the accelerator for too long. Most importantly, by linking to economic conditions, the Fed would not be providing an open-ended promise to monetize the federal debt.

For those of us who think the Fed should be doing more this symposium indicates we still have our work cut out for us in convincing others.

Wednesday, September 8, 2010

Can the US economy really return to “business as usual” when it has 4 million houses surplus to requirement, when 1 out of 4 mortgages are in negative equity, and when by our calculation, it is burdened with $4 trillion of excess mortgage debt, equivalent to 30% of GDP?

For many years, total mortgage debt consistently and reliably equalled 0.4 times the value of the US housing stock. Intuitively, this average of 0.4 makes perfect sense as every property usually has a mortgage ranging from 0 to 0.9 times its value. So in 1990, $6 trillion of housing collateral could support $2.5 trillion of mortgages, and by 2006, $23 trillion of housing collateral could support $10 trillion of mortgages. But since then, the US housing stock’s value has slumped to $16 trillion which means the amount of mortgage lending supportable by the collateral has plunged to $6 trillion. However, actual mortgage debt has remained at $10 trillion – $4 trillion too high.

The fact that mortgage debt has barely declined suggests that relatively few homeowners have defaulted on their mortgages or paid off debt yet. Instead, a quarter of all borrowers are sitting on negative equity. That’s just as well – because were mortgage debt to shrink by even half of $4 trillion, the US economy would slump.

Here is the accompanying figure:

[Update: the greenish line in the top panel should be labeled "U.S. residential real-estate assets multiplied by 0.4." The 0.4 represents the how much mortgage debt has been as a percent of the U.S. housing stock historically. Joshi considers it the sustainable level of mortgage debt given the collateral value of housing. I added the second paragraphs above to make this clearer.]

It seems increasingly clear that we must [let house prices fall]. For how long can the government prop them up? Are we never to have a private market in mortgages again?

Yet what happens if we let them fall? Arguably many banks would once again be "under water." Enthusiasm for another set of bailouts is weak, to say the least. Our government would end up nationalizing these banks and it still would be on the hook for their debts. The blow to confidence would be a major one, especially if along the way we saw a recreation of a Lehman or Bear Stearns or A.I.G. episode.

I increasingly believe there is no easy way out of this dilemma and it is a major reason why the U.S. economy remains stuck. Housing prices must fall, yet...housing prices must not fall.

What a mess we are in. So what can be done? My recommendation is (1) have the Fed take more aggressive actions to stabilize the macroeconomy which would make it easier to (2) do the structural changes needed to address the problems outlined above. One specific structural proposal would be to swap underwater mortgage debt for equity. What suggestions do you have?

James Kwak is incensed at how ECON 101 has warped people into thinking it is appropriate to let prices rise following a sudden shortage in supply, such as after a natural disaster. He decries the fact that "Econ 101 is diametrically opposed to human beings’ intuitive sense of fairness. Yet public policy largely follows the dictates of Econ 101." I was surprised to read this coming from the normally thoughtful James Kwak. I was even more surprised to see that the best he could to justify such price gouging was the following:

They [the folks who believe a price increase is okay] know enough to know that if there is a demand shift, not only is it OK to raise prices, but you should raise prices in order to clear the market. In this case, supply is fixed in the short term, so raising the price won’t increase supply; the Econ 101 argument is that raising the price allocates the shovels to people who will derive more utility from them (because they will pay more), thereby increasing social welfare.

Of course, he quickly dismisses this line of reasoning:

But this rests on a huge assumption: that willingness to pay is the same as utility. Unfortunately, however, this assumption fails in the real world; poor people simply can’t pay as much for snow shovels as rich people, and as a result a price increase will allocate shovels to rich people, not to those who need them the most.

As noted by Adam Ozimek this analysis is woefully incomplete. Here is an edited version of the comments I left at Kwak's blog:

The analysis is grossly inadequate here. First, the supply may be fixed in the short run, but by allowing prices to rise there will be eventually an increase in supply. For example, a town hit by a hurricane does have a fixed supply of generators. If prices are allowed to rise then at some point they get high enough to induce suppliers from outside the city to start bringing additional generators to the devastated area. If there is no price increase they have no incentive to send their extra generators. Likewise, good old boys from out of town may decide it is worth their while to throw some chainsaws and other tools in the back of their pickups and head down to disaster-hit town if they think they can earn higher fees. If price gouging laws are put into place these good old boys stay at home and the recovery takes longer. In short, by allowing higher prices there is a dynamic effect on supply that ultimately improves human welfare.

Second, the critique that willingness to pay is not the same as utility similarly misses some important points. It ignores that the “rich” people may be banks, grocery stores, and hospitals–the very entities we want scarce resources like generators going to in a crisis so that we can get money, food, and healthcare. It also ignores the fact if resources aren’t allocated by price they will be allocated by other means that will not seem anymore fair. For example, owners of hardware stores might allocate by first come, first serve or by who they know. One can easily imagine the “rich” getting to the hardware store first or the connected getting the goods because they know the owner. The big point here is that Kwak's analysis offers up no meaningful alternative allocation method and that is because there is none.

ECON 101 also tells us that if folks like Kwak want a more equitable outcome then give out income vouchers or some other kind of income subsidy during the crisis. That way you get relief to those in need without distorting the price system, the very thing which works to hasten the recovery. If you truly care about improving human welfare in such circumstances your battle cry should be "Gouge Away!"

Tuesday, September 7, 2010

It's still happening. Eight months on and counting, expected inflation continues to fall at a steady pace as seen below: (Click on figure to enlarge.)

Several things to note about this remarkable downward trend.

First, given that productivity is now declining this picture screams out that total current dollar spending is expected to decline. That is, the market expects weaker aggregate demand (AD) in the future and, as a result, there will be lower inflation. Even if one is convinced that this downward trend is being driven in part by a heightened liquidity premium the implication is the same. A heightened liquidity premium indicates increased demand for highly liquid assets like treasuries and money which, in turn, imply less aggregate spending. Recent AD forecasts support this interpretation.

Second, the spread has on averaged declined about 0.55 basis points a day over the January 4, 2010 - September 2, 2010 period. At this pace and with no policy change, zero inflation expectations will be hit sometime around March 2011. Thereafter, it's a deflation expectation world.

Third, the Fed has done nothing meaningful to arrest this downward trend. The biggest move it made was on August 10 when it announced plans to stabilize the size of its balance sheet. The spread continued to fall after the announcement. The failure of the Fed to stabilize this downward trend amounts to the Fed passively tightening monetary policy. Lest you think I am being too critical here, Bernanke admitted in his Jackson Hole speech that Fed was passively tightening by not stabilizing the Fed's balances sheet. By his own logic then, the Fed is tightening by allowing inflation expectations to deteriorate.

Finally, this is the longest-running decline for this spread since the daily TIPS data for this maturity became available in 2003. Yes, the 2008 decline is larger, but it only lasts from July to November, 5 months. This decline is going on 8 months now with no end in sight. If the Fed continues to ignore this downward trend one can only imagine how ingrained these expectations will become.

There is a lot of chatter right now about whether a payroll tax holiday would provide an effective stimulus to the slumbering U.S. economy. The motivation for this chatter is the news that the White House is considering, among other things, some kind of payroll tax cut. The discussion so far has been mixed with some folks like Scott Sumner, Tyler Cowen, and Arnold Kling endorsing it while others like Megan Mcardle and Mark Thoma expressing uncertainty as to how much stimulus it would actually provide. Mark Thoma concludes his discussion of this proposed tax cut with the following:

Thus, the overall effect on employment depends upon the net effect of the AD and AS shifts. If the AD shift dominates, as I suspect it would, it's still possible for this policy to have positive effects on output and employment. But the size of the effect depends upon the strength of the demand side shift, and how strong the shift would be is an open question, particularly given the degree of household balance sheet rebuilding we are seeing which causes the tax cuts to be saved rather than spent.

See the rest of Thoma's post as to why a payroll tax could affect both aggregate supply (AS) and aggregate demand (AD). One way to make sure the AD effect dominates would be to do the payroll tax holiday in the manner I suggested a few days ago: have the Federal Reserve (Fed) fund the payroll tax holiday with a "monetary gift" to the Treasury department and at the same time commit the Fed to doing so until a certain nominal target (e.g. a price level target) is hit. As discussed in the comments in my previous post, only part of this funding would truly be a "monetary gift" from the Fed. Still, the announcement of a nominal target to complement the payroll tax holiday would go a long ways in stabilizing the nominal expectations.

With all that said, I am not advocating this approach as my first-best solution. I would rather go with more aggressive monetary policy along the lines Scott Sumner discusses here. If, however, there is going to be a payroll tax holiday, why not make it more effective by bringing in the Fed's money helicopter? The biggest impediment to this proposal is a legal one, it would require Congressional approval.
Update: I overstated Tyler Cowen support for the payroll tax cut.

Dean Baker provides a nice follow-up to my last post. He argues the Fed could and should have done something to stem the housing boom back in 2003-2004. His post reminds me of the interview Alan Greenspan did on the House of Cards documentary. In it, Greenspan claims that if the Fed had tried to stop the housing boom it would have (1) caused a recession and (2) faced political backlash for stalling the drive for increased home ownership. I am not convinced of (1), but even if it were true surely a recession in 2003 would have been far milder than the Great Recession we are working our way through now. Household balance sheets would not be the wreck they are today and, as a result, neither would government balance sheets be so damaged (i.e. public spending stepped in to replace private spending during the recession and thus created a mess in government's balance sheet). On (2), the whole point of central bank independence is to be able to make the tough, unpopular call sometimes. Anyways, here is Dean Baker:

[The NYT] notes Bernanke's statement that in 2003-2004 it was not clear that the housing market was in a bubble and that by the time it was clear, it was too late for the Fed to do anything without seriously harming the economy. Of course it was clear as early as 2002 that the housing market was in a bubble, but more importantly, Bernanke's claim that the Fed could not act until it was clear is absurd.

The Fed always acts in an uncertain environment. For example, Alan Greenspan raised interest rates in anticipation of inflation on numerous occasions. The logic of this action was that it was worth slowing the economy and raising the unemployment rate rather than risk an increase in the rate of inflation. In effect, this action assumes that the certainty of higher unemployment from raising interest rates is better than the risk of higher inflation.

Had the Fed acted to burst the bubble in 2003-2004, the risk would have been that it temporarily depressed house prices by scaring people about excessive prices and limiting the exotic mortgages that were boosting demand. By contrast, if it had acted correctly in preventing the growth of a dangerous bubble, it would have prevented the worst downturn in 70 years.

Any serious weighing of the benefits and risks of bursting the bubble in 2003-2004 would have surely come down in favor of bursting the bubble. The Fed's decision not to burst the bubble was one of the most disastrous failures of monetary policy in history.

I really did not want to revisit this question since I have already covered it here many times before. Folks, however, are talking about it again given its coverage at the Fed's Jackson Hole conference. Mark Thoma, for example, has posted several pieces on it in the past few days. Most of this renewed discussion has taken a less critical view of the Fed's role during the housing boom, specifically the role played by the Fed's low interest rate policy. I feel compelled to rebut this Fed love fest since there are compelling reasons to believe the Fed did play an important role in creating the housing boom. To be clear, I do not see the Fed as the only contributor--far from it--but it does appear to be one of the more important ones. Here is my list of reasons why:

(1) The Fed kept its policy interest rate, the federal funds rate, below the natural or neutral interest rate for an extended period. It is not correct to say the Fed kept interest rates very low and thus monetary policy was very loose. Interest rates can be low because the economy is weak, not just because monetary policy is stimulative. Interest rates only indicate a loosening of monetary policy if they are low relative to the neutral interest rate, the interest rate level consistent with a closed output gap ( i.e. the economy operating at its full potential). There is ample evidence that the Fed during the 2002-2004 period pushed the federal funds rate well below the neutral interest rate level. For example, see Laubach and Williams (2003) or this ECB study (2007). Below is graph that shows the Laubach and Williams natural interest rate minus the real federal funds rate. This spread provides a measure on the stance of monetary policy--the larger it is the looser is monetary policy and vice versa. This figure shows that monetary policy was unusually accommodative during the 2002-2004 period. This figure also indicates an important development behind the large gap was that the productivity boom at that time kept the neutral interested elevated even as the Fed held down the real federal funds rate.

(2) Given the excessive monetary easing shown above, the Fed helped create a credit boom that found its way--via financial innovation, lax governance (both private and public), and misaligned incentives--into the housing market. Housing market activity was further reinforced by "the search for yield" created by the Fed's low interest rates. The low interest rates at the time encouraged investors to take on riskier investments than they otherwise would have. Some of those riskier investments end up being tied to housing. Thus, the risk-taking channel of monetary policy added more fuel to the housing boom.

(3) Given the Fed's monetary superpower status, its loose monetary policy got exported across the globe. As a result, the Fed helped create a global liquidity glut that in turn helped fuel a global housing boom. The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy was exported to much of the emerging world at this time. This means that the other two monetary powers, the ECB and Japan, had to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's loose monetary policy also got exported to some degree to Japan and the Euro area. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s. Inevitably, some of this global liquidity glut got recycled back into the U.S. economy and further fueled the housing boom (i.e. the dollar block countries had to buy up more dollars as the Fed loosened policy and these funds got recycled via Treasury purchases back to the U.S. economy). Below is a picture from Sebastian Becker of Deutsche Bank that highlights this surge in global liquidity:

For these reasons I believe the Fed played a major role in the credit and housing boom during the early-to-mid 2000s. Let me close by directing you to Barry Ritholtz who gives more details on how the Fed's policy distorted incentives in financial markets.

Update: An good question was raised in the comments section: if the federal funds rate was below the neutral rate for so long, then why was there disinflation? The answer is that the same productivity boom that kept the neutral interest rate elevated also created deflationary pressures. The Fed saw the disinflation and acted as if it were created by weak aggregate demand (AD). Instead, it should have been less concerned since it was strong aggregate supply (i.e. the productivity gains) creating the disinflation at the time. AD, in fact, was not falling during this time and could not have been the source of the low inflation. The figure below illustrates this point. It shows the productivity surges at this time coincided with the two sustained drops in inflation while demand growth surged. (Click on figure to enlarge.)

Thursday, September 2, 2010

I believe the Fed can and should be doing more to create a more stable macroeconomic environment. There is much they can yet do to stabilize aggregate spending and improve economic certainty. However, even if we were to get this from the Fed it still would not solve all our economic problems. We are in the midst of a massive deleveraging cycle by households and unless something radical happens likeswapping the underwater portion of household mortgages for equity this process will probably take years to unfold. Ken Rogoff reminds us of this point in a recent article:

What more, if anything, can be done? The honest answer – but one that few voters want to hear – is that there is no magic bullet. It took more than a decade to dig today’s hole, and climbing out of it will take a while, too. As Carmen Reinhart and I warned in our 2009 book on the 800-year history of financial crises (with the ironic title “This Time is Different”), slow, protracted recovery with sustained high unemployment is the norm in the aftermath of a deep financial crisis.

The only palliative he sees is higher inflation:

Given the massive deleveraging of public- and private-sector debt that lies ahead, and my continuing cynicism about the US political and legal system’s capacity to facilitate workouts, two or three years of slightly elevated inflation strikes me as the best of many very bad options, and far preferable to deflation. While the Fed is still reluctant to compromise its long-term independence, I suspect that before this is over it will use most, if not all, of the tools outlined by Bernanke.

I too don't want to comprise the Fed's long-run inflation credibility. That's why I want a NGDP level target (my first choice) or price level target (my second choice... I really don't like this one but I will settle for it). It would create some higher (catch-up) inflation until we hit some target level and stabilize thereafter. If this policy were made explicit it would do much to stabilize economic expectations, a big plus in our current mess. Again, this will not fix our structural problems, but it would create a more stable macroeconomic environment in which to make the needed structural adjustments. Now if we could get more discussion on proposals to hasten the restoration of household balance sheets, such as the one to swap underwater mortgage debt for equity, maybe the structural adjustments could be expedited too.

Wednesday, September 1, 2010

Some observers say the Fed is out of ammo, that any further attempts by it to stimulate nominal spending is like pushing on a string--it's futile. This understanding ignores the fact that the Fed has yet to use all of its big guns and that these guns were found to be highly effective in ending the Great Contraction of 1929-1933. Moreover, Fed officials including Bernanke believe the Fed could do more if it wanted to do so. So the "Fed is pushing on a string" folks are simply wrong. Still, it is always useful to consider exactly how the Fed could stimulate total current dollar spending. Ricardo Caballero does just that in his recent proposal to have the Fed do a helicopter drop via the U.S. Treasury Department. His proposal is very explicit in how it would work and with a few minor tweaks I believe it could be effective in stabilizing aggregate demand. Here is Cabellero:

[T]he Federal Reserve has the resources but not the instruments, while the US Treasury has the policy instruments but not the resources. It stands to reason that what we need is a transfer from the Fed to the Treasury...what we need is a fiscal expansion (e.g. a temporary and large cut of sales taxes) that does not raise public debt in equal amount. This can be done with a “helicopter drop” targeted at the Treasury. That is, a monetary gift from the Fed to the Treasury.

I would tweak this proposal in two ways. First, I would do fiscal expansion via a payroll tax holiday. Second, I would announce that this payroll tax holiday would be contingent on hitting an explicit nominal GDP or price level target. Thus, as long as the target was not being met the payroll tax holiday would be in effect. I really like this proposal for the following reasons:

The money is sent directly to the public; it bypasses the credit-clogged banking system and puts into the hand of the spenders.

There is no increase in the public debt, thus there is no Ricardian Equivalence problems.

It is politically feasible: the Republicans get a payroll tax cut and the Democrats get fiscal expansion.

It is radical enough to work. To change expectations there has to be some shock-and-awe break from the current policy of allowing declines in inflation expectations, core prices, and nominal spending. This should do it.

The biggest drawback to this proposal is the issue of how the Fed could unwind the monetary expansion at a later date. This program would have the Fed increase its liabilities (i.e. the monetary base) without any offsetting increase in Fed assets (e.g. treasury securities). Having these assets available would be important for the Fed down the road if, say after the economic recovery, it needed to pull back some of the money created through this program. Caballero suggest the Fed could use some of its new tools (e.g. Fed term deposits ) or add contingency conditions that would require the Treasury to return money to the Fed. None of these solutions would be painless. Felix Salmon suggests a way around this problem is simply to front-load the seigniorage (i.e. Fed profit) returned to the Treasury. It is unclear, though, how well this would work. Seigniorage is limited and thus the Fed could not unconditionally commit to an explicit NGDP or price level target with it. It would therefore be difficult shake deflationary expectations. One soultion might be to have the Fed simply buy treasury securities directly from the U.S. Treasury instead of giving it a "monetary gift" via a helicopter drop. As long as the Fed held securities there would be no increase in the amount of publicly held debt. Some of the debt may ultimately leak bank into the public domain if the Fed used it to reverse some of the monetary expansion. As long as the leakage was not too much the same benefits outlined above would apply.